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Post-Fed Pivot Clarity

Crescent Capital Markets Commentary by John Fekete.

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Post-Fed Pivot Clarity

2024 looks to be the year of the pivot as the Federal Reserve tames inflation while the economy remains resilient. John Fekete, Crescent Capital Group’s Head of Capital Markets, discusses the state of the U.S. economy and the outlook for debt markets.

What was the biggest story of 2023?

The biggest story of 2023 was the durability of the U.S. economy. One of the most widely anticipated recessions in history never materialized, so many of the prognosticators were just plain wrong. Back in July, we published a commentary called “We’re not out of the woods yet, but time to step in” where we mentioned we were on the bullish side of the recession debate and called attention to the attractiveness of the high yield bond and bank loan markets. The yield curve inversion proved to be an imperfect indicator while labor market strength proved prescient. We learned it was possible for the Fed to dramatically dampen inflation without sacrificing jobs—achieving its two mandates simultaneously.

How did 2023 shape up for high yield bond and syndicated loan investors?


High yield bonds returned 8.3% for the final two months of the year, which lifted the annual return for 2023 to 13.5%, per Morningstar indices, as spreads tightened and yields dropped in the fourth quarter. High yield bonds narrowly outperformed leveraged loans (13.3%) and trumped an 8.4% gain for investment grade bonds. Rising stars outpaced fallen angels by a ratio of 4.6:1, the fastest pace since 2007, according to Goldman Sachs. While new issuance was modest, it skewed toward higher quality. Triple-C rated new issuance was only 5% of total high yield issuance in 2023 according to Dealogic, the lowest in the post-GFC period.

It seems a lot has changed over the past quarter. Has the rally gotten ahead of itself?

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So much has changed, for sure. The great monetary pivot is here as inflation approached targeted levels faster than expected. Once considered highly unlikely by many investors, a soft landing has been engineered by central bankers. On December 13, the Fed provided clarity by stating that the rate hiking cycle is over and acknowledged internal discussions regarding the timing and pace of rate cuts in 2024. In his press conference that day, Fed Chair Jay Powell acknowledged that rate cutting would need to happen “way before” inflation returned to its 2% target. This policy shift comes as the U.S. credit markets experienced their own soft landing of sorts. Corporate defaults remain at or below long-term averages despite two years and 525 basis points of interest rate hikes. The net result is that interest rate policy now goes from being a headwind to a tailwind—at a time when recession risk is relatively low, the outlook for defaults is modest, and corporate fundamentals are constructive. Combined, these factors provide a clear signal that the market outlook has improved.

What is your outlook for credit in 2024?


We foresee equity-like returns in credit in 2024 assuming current economic conditions continue. There is a finite window of opportunity coming out of a once-in-a-century pandemic and the resulting inflation that followed where investors can benefit from a gradual decline in interest rates while the economy remains strong and growing. This unprecedented scenario will continue to bode well for fixed income. Credit fundamentals remain positive, although some of this strength is expected to moderate as economic growth likely cools. We continue to see most borrowers realistically projecting revenue and cash flow growth, resulting in stable leverage ratios. With a resilient consumer, strong labor market, and monetary policy leaning toward rate cuts rather than additional hikes, high yield bond, bank loan and CLO debt investors are likely to realize high single-digit returns in 2024 without any additional spread compression. As the Fed implements the cuts it has signaled and the yield curve steepens, the relative value of holding cash and other risk-free assets will start eroding. For instance, investment grade corporates won’t appear overly compelling given that 71% of the investment grade corporate market yields less than 3-month US Treasury bills, according to Goldman Sachs as of 4Q 2023. Investors can harvest carry in high yield bonds, syndicated loans and CLO debt with more confidence today than over the past 12 months.

Do you have a favorite fixed income sector right now?

With base rates sitting around 5.3% floating rate instruments like syndicated bank loans and CLO debt offer near double-digit coupons, providing a significant carry pick-up over fixed coupon bonds. It would take a rapid decline in interest rates for high yield bonds to outperform syndicated loans and CLO debt, so we have an allocation preference for floating rate sectors in multi-asset portfolios.

What risks do you see now and as 2024 progresses?

One risk that receives little attention is that global fiscal deficits are out of control. Sovereign debt issuance is soaring. According to the Financial Times, the U.S. Treasury will issue approximately $4 trillion of bonds this year with a maturity of two to 30 years, up from $3 trillion last year and $2.3 trillion in 2018. Furthermore, national elections will occur in more than 50 countries in 2024, home to half the planet’s population. History shows that politicians boost public spending rather than exercise fiscal restraint in election years. This is a concern for investors, including us, but it is a slow-moving train and one that won’t likely have a material near-term impact. The biggest immediate risk I see facing investors is the risk of falling into the same trap they have for the last two years –underestimating the strength of the U.S. economy and the ability of the Fed to break inflation without millions of Americans losing their jobs.

What about interest coverage and defaults? They have been a recent focus for investors.

Coupons, or the rates borrowers pay, are likely to be at or near their peaks with the rate hiking cycle concluding in the U.S. While still-high interest rates may pressure certain borrowers, many have adequate liquidity and would likely benefit from private equity sponsor support if needed.

We have lowered our 2024 corporate default outlook to 3-5% from 4-6% as financial conditions have dramatically eased since November. And recoveries post-default, which have been well below historical averages, are stabilizing. After dipping below 60% in 2Q 2023, syndicated loan recoveries have modestly increased to 45% while high yield recoveries have been steady at 43% according to UBS. A word from years of experience of seeing calm after a storm—do not underestimate the casualties. We approach underwriting with extreme care and diligence to avoid tailwind complacency.

Crescent is a global credit investment manager with over $40 billion of assets under management as of September 30, 2023. For over 30 years, the firm has focused on below investment grade credit through strategies that invest in marketable and privately originated debt securities including senior bank loans, high yield bonds, as well as private senior, unitranche and junior debt securities. Crescent is headquartered in Los Angeles with offices in New York, Boston, Chicago and London with more than 200 employees globally. Crescent is a part of SLC Management, the institutional alternatives and traditional asset management business of Sun Life. For more information about Crescent, visit www.crescentcap.com.

This document expresses the views of the author as of the date indicated and such views are subject to change without notice. Neither the author nor Crescent Capital Group LP (“Crescent”) has any duty or obligation to update the information contained herein. Further, Crescent makes no representation, and it should not be assumed, that past investment performance is an indication of future results.

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